The default business structure for most people forming a business today is the Limited Liability Company (LLC). LLCs are a good choice because in an LLC structure, owners have limited personal liability for the debts and actions of the LLC. But there are two other options most people don’t consider when starting a business: the C corporation and the S corporation. Let’s look at the difference between these two types of corporations.
C corporations are the standard, and if you don’t file specifically for S status when you set up your corporation, it’s automatically a C corp. Both classifications give you limited liability, but when it comes to taxes there is one major difference: distributions of profits from a C corporation are taxed twice. The corporation pays tax on its net income, and shareholders also pay tax on distributions as dividends. The only consolation is that dividends are taxed as capital gains. Income from an S corporation is only taxed once at the shareholder level.
If you’re a small business trying to decide how to set up your business, here are a few things to keep in mind for tax purposes:
- A C corporation doesn’t make a lot of sense unless you’re planning to grow very large very quickly, because of the double tax on income and proceeds from sales. There are some benefits that C corps offer but for small businesses the benefits are far outweighed by the double taxation.
- An S corporation can be a good choice for owners who prefer the corporate form over the LLC. The S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. Instead, with an S corporation, the business profits are taxed at individual tax rates on each shareholder’s Form 1040. The accounting rules are more complicated than if you’re filing as a sole proprietor, requiring different forms and quarterly filings, but these requirements are fairly easily met, and the tax savings is usually substantial.
- Because the federal government does not recognize an LLC as a classification for federal tax purposes, an LLC can file a corporation, partnership, or sole proprietor tax return. It can be advantageous for a business to elect to file an S corporation return, because you get the tax advantages of being an S corp. If your business is an LLC, you may want to talk to your CPA about filing an S Corp return to see how much money it would save you.